What Is the 5 Rule in Real Estate? A Clear Guide for Commercial Property Buyers
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When you’re buying commercial property, you’re not just looking at square footage or rent rolls. You’re betting on cash flow, location, and long-term stability. One of the most talked-about rules in commercial real estate is the 5 rule. It’s not a law. It’s not a government guideline. But if you’ve worked with seasoned investors in Auckland, Sydney, or even Chicago, you’ve heard it: the 5 rule says a commercial property should generate at least 5% net operating income (NOI) after all expenses, but before debt service.
What the 5 Rule Actually Means
The 5 rule is a quick filter. It helps you decide whether a commercial property is even worth looking at closely. If a building is priced at $1 million and brings in $50,000 in annual net income after taxes, insurance, maintenance, property management, and vacancy allowances - that’s a 5% return. That’s the baseline.
Why 5%? Because commercial properties carry more risk than residential. Tenants can leave. Leases can expire. Vacancies last longer. Repairs cost more. A 5% return isn’t glamorous, but it’s the minimum threshold many investors use to avoid overpaying. In Auckland’s CBD, where land prices have climbed over 40% since 2020, hitting 5% is harder than it used to be. But it’s still the starting line.
Here’s how it breaks down:
- Annual gross rental income: $75,000
- Minus property taxes: $12,000
- Minus insurance: $3,000
- Minus maintenance and repairs: $5,000
- Minus property management (8% of rent): $6,000
- Minus vacancy allowance (5% of rent): $3,750
- Net Operating Income (NOI): $45,250
Now divide NOI by purchase price: $45,250 ÷ $1,000,000 = 4.53%. That’s under 5%. You’d walk away - unless you see room to raise rents, cut costs, or negotiate a lower price.
Why It’s Not About Gross Rent
Many new investors get fooled by gross rent. A landlord might say, “I get $80,000 a year in rent.” Sounds great. But if the building needs a new roof, the tenant pays for utilities, and the property manager takes 10%, your actual take-home might be half that. The 5 rule forces you to look at what’s left after everything is paid.
In 2024, a commercial property in Manukau was listed at $1.8 million with $100,000 in gross rent. The buyer ran the numbers: $18,000 in taxes, $7,000 in insurance, $12,000 in maintenance, $8,000 in management, and a 7% vacancy buffer. NOI came to $55,000. That’s 3.06%. The buyer walked. Three months later, the seller dropped the price to $1.5 million. NOI jumped to 3.67% - still under 5%, but closer. A new tenant signed a 5-year lease. The buyer got in at 4.2%. Not perfect, but better.
When the 5 Rule Doesn’t Apply
The 5 rule is a filter, not a gospel. There are exceptions.
Prime locations - like Wynyard Quarter in Auckland - often trade below 4% because buyers expect long-term appreciation, not just income. These are speculative plays. You’re betting the area will keep growing. That’s fine - but you need to know you’re making that bet.
Triple-net leases (NNN) shift almost all expenses to the tenant. In these cases, NOI is higher because the landlord doesn’t pay taxes, insurance, or maintenance. A property with $60,000 NOI on a $1 million price tag might be a 6% return - but only because the tenant handles everything. These deals are rare and usually involve national chains like McDonald’s or pharmacies.
Distressed assets - buildings with bad tenants or outdated systems - can be bought below market. You fix them up, raise rents, and push the return above 5%. That’s not the 5 rule failing. That’s you using it as a starting point to find value.
How to Use the 5 Rule in Practice
If you’re serious about commercial real estate, here’s how to use the 5 rule without getting fooled:
- Start with the NOI. Don’t trust the seller’s rent number. Ask for the last 12 months of operating statements. Verify every expense.
- Use realistic vacancy rates. Don’t assume 2%. In Auckland’s retail sector, 5-7% is normal. For offices, 4-6%. Ask your agent for local averages.
- Factor in future costs. Does the roof need replacing in 3 years? Are the HVAC systems older than 15 years? Add $10,000-$30,000 to your maintenance budget.
- Compare to similar sales. Check recent transactions in the same suburb. If all 3 similar buildings sold at 5.5%, and this one’s at 4.2%, you’re overpaying.
- Walk away if it’s below 4%. Unless you have a clear plan to improve it, don’t force it. There are always other deals.
What Happens When You Ignore the 5 Rule
In 2022, a Wellington investor bought a retail strip center for $2.1 million because the seller promised “high occupancy.” The gross rent was $110,000. He didn’t check expenses. Turned out, the property had $65,000 in annual costs - taxes, insurance, repairs, and management. NOI was $45,000. That’s a 2.14% return. He was paying $10,000 a year just to cover his mortgage. He sold it two years later at a $200,000 loss.
That’s what happens when you skip the math. The 5 rule isn’t about being greedy. It’s about avoiding financial traps.
Is 5% Still Realistic in 2026?
Interest rates are higher. Construction costs are up. Tenant demand in some sectors is soft. But the 5 rule still holds - because it’s not about what’s easy. It’s about what’s sustainable.
In Auckland, industrial warehouses near the airport are still hitting 6-7% returns. Medical office buildings in suburbs like Manukau are at 5-5.5%. Retail spaces in smaller towns? Often below 4%. The market isn’t broken. It’s just selective.
If you’re looking for 8% returns, you’re chasing risk - not value. The 5 rule helps you stay in the game without gambling.
What to Do Next
Don’t start with a property. Start with your numbers.
Grab a spreadsheet. List:
- Your target purchase price
- Your estimated gross rent
- Your estimated expenses (taxes, insurance, maintenance, management, vacancy)
- Your NOI
- Your cap rate (NOI ÷ price)
If the cap rate is under 4%, ask why. Is the location improving? Are leases about to renew at higher rates? Or is this just a bad deal?
The 5 rule doesn’t guarantee success. But it keeps you from making the same mistakes most new investors make. It turns emotion into analysis. And in commercial real estate, that’s the difference between building wealth and losing it.
Is the 5 rule the same as the 1% rule in residential real estate?
No. The 1% rule says monthly rent should be at least 1% of the purchase price - so a $500,000 house should rent for $5,000/month. That’s for single-family homes. The 5 rule is for commercial properties and uses annual net income, not gross rent. They’re different tools for different markets.
Can I use the 5 rule for mixed-use buildings?
Yes, but you need to separate the income and expenses for each use. A building with retail on the ground floor and offices above? Calculate NOI for each section independently, then combine. Retail usually has higher rent but higher vacancy risk. Offices have lower rent but longer leases. The 5 rule still applies to the total NOI divided by total price.
What if a property has a long-term tenant locked in?
That’s a plus - but don’t ignore the 5 rule. A tenant with 10 years left on lease might justify a slightly lower return, say 4.5%. But if the cap rate is below 4%, you’re still taking on too much risk unless you’re certain the tenant will renew or the building can be sold for a higher price later.
Does the 5 rule include mortgage payments?
No. The 5 rule uses Net Operating Income (NOI), which is before debt service. Your mortgage payment is separate. That’s why the 5 rule helps you assess the property’s cash flow potential - not whether you can afford it. You still need to run your personal debt-to-income numbers separately.
Are there other rules I should know besides the 5 rule?
Yes. The 2% rule (for residential) and the 70% rule (for fix-and-flip) are common. But for commercial, focus on cap rate, cash-on-cash return, and rent-to-price ratio. The 5 rule is your first filter. After that, dig into lease terms, tenant credit, and market trends.
Final Thought
The 5 rule isn’t magic. But it’s simple. And in a market full of flashy listings and aggressive sellers, simplicity is your advantage. If a deal doesn’t meet it, walk away. There’s always another one. The best commercial deals aren’t the ones that scream the loudest - they’re the ones that make sense on paper.
